Conference on Fiscal Policy Frameworks: A Review

1
Conference on Fiscal Policy Frameworks A Review

• August 2007
• David Vines
• University of Oxford, Australian National
  University, and CEPR

2

• The conference began by discussing the gradual
  establishment of a framework of constrained
  discretion for fiscal policy in Australia and New
  Zealand
• In both economies there is an inflation targeting
  regime in which
• monetary policy is responsible for the short run
  stabilisation of the economy
• In both economies there is concern about
• the constraint what should be the long run role
  of fiscal policy
• The discretion - should fiscal policy do to help
  monetary policy stabilise the economy in the
  short-run
• The conference was about monetary-fiscal
  interactions

3
1 Principles

• Key message of modern macroeconomic theory
  Taylor rule macro
• monetary policy should do short run stabilisation
  of the economy
• fiscal policy should be concerned with longer run
  issues, and for short-run concerns it should
  ensure that the issue of public debt is properly
  constrained .
• Four reasons
• History collapse of Bretton Woods, and
  Mundell-Fleming insight (worked out at the IMF in
  the early 1960s)
• Fiscal policy works well under fixed exchange
  rates
• Monetary policy powerful under floating exchange
  rates
• Changing fiscal policy is costly
• Fiscal policy is slow monetary policy can act
  rapidly
• Political economy reasons we now have
  independent central bank whereas fiscal policy
  risks politicising the management of the economy
  to avoid this risk this policy should be
  constrained so as to ensure a non-excessive
  supply of public debt.
• But questions remain about this stabilise with
  monetary policy only story

4
2 Australian and New Zealand Experience

• Australia David Gruen and Amanda Sayegh The
  Evolution of Fiscal Policy in Australia
• This paper focuses on medium term influences,
  rather than on counter-cyclical stabilisation in
  the short-term.
• it documents a concern, in the 1980s, with the
  current account deficit
• this propelled a concern with raising national
  savings
• the focus has gradually given way to a concern
  with national savings itself.
• Ageing and public health costs
• Pensions much less of an issue in Australia then
  elsewhere in the OECD
• This framework has led to the evolution of a
  rules-based framework in which there is room
  for discretion similarities with the Australian
  approach to inflation targeting a search for
  constrained discretion
• The trilogy
• The charter of Budget honesty formed the basis
  from 1996
• Intergenerational Report 2002 leading to a
  focus on intergenerational equity and fiscal
  sustainability

5

• To this listener it posed the question
• How big should the surplus be? Should it respond
  to
• rising personal indebtedness
• the large terms of trade boom
• The paper - written in 2005 noted that until
  then fiscal policy had been anticyclical
• To this listener it appears that unanticipated
  increases in revenue have recently caused fiscal
  policy to become pro-cyclical
• Overall, the Australian experience leads one to
  ask should fiscal policy have a role to play in
  assisting the role of monetary policy in
  stabilising the economy in the short-term
• How should a fiscal policy, even if it is focused
  on the medium term, play this short term
  question?
• What rules should govern this medium term
  perspective?

6

• New Zealand Felicity Barker, Robert Buckler and
  Robert St Clair Roles of Fiscal Policy in New
  Zealand
• This paper discussed medium term influences, and
  also shorter-term counter cyclical issues, and
  also practical questions of implementation and
  structure.
• New Zealand experience also shows the emergence
  of a rules-based structure. The Public Finance
  Act of 1989 (PFA) was important in this.
• Determination of principles of responsible
  management
• Development of reporting requirements
• The emergence of long term objectives to reduce
  long term debt
• 2003 - a new fiscal management approach

7

• There is also an important discussion in the
  paper of fiscal structure and how, at the
  practical level, well functioning policy can be
  established.
• In addition, the paper has an important section
  on the role of fiscal policy in short-term
  stabilisation
• Concerns have been noted in New Zealand about the
  effect of being in an environment of highly
  integrated international capital markets.
• The carry trade and the transmission mechanism of
  monetary policy
• Could fiscal policy be more counter cyclical?

8
3 Theoretical discussion about the discretion

• 3.1 Is it optimal for fiscal policy to leave all
  stabilisation to monetary policy?
• Paper presented by Nicola Giammarioli about the
  US, treated a closed economy
• Even if monetary policy does the best it can,
  then there is more that fiscal policy can do. The
  simplest version of the idea is that fiscal
  policy and monetary policy have different
  relative effects on inflation and output
• Let monetary policy aim for a level of output
  which stabilises inflation
• Fiscal policy can lower this level of output (eg
  by cutting taxes or by causing currency
  appreciation)
• Thus the use of two instruments thus might
  improve outcomes
• In an open economy like Australia and New Zealand
  there is another, perhaps more important argument
  for the use of fiscal policy as well as monetary
  policy it prevents the burden of stabilisation
  falling on the traded goods sector, and/or can
  help this shelter that sector from shocks of this
  kind touched on earlier.
• There may be an advantage in setting up a
  temporary future fund to help to save an
  economy from a temporary terms of trade shock
  Norway

9
3.2 Might fiscal policy be so irresponsible
that it jeopardises the control of
inflation?

• Paper presented by Eric Leeper
• Eric Leeper pioneered fifteen years ago the
  fiscal theory of the price level the view
  that fiscal policy might not constrain public
  debt there may come times in which fiscal
  imprudence becomes so great that it might not
  prove possible for monetary policy to control the
  inflation rate.
• He presented a technical paper to the conference
  on a related issue. If there is a large fiscal
  stimulus an increase in public debt as at
  present in the US - then we have to ask how will
  the government ensure solvency in the face of
  this very large increase of public debt. Is it
  taxes which will be increased in the future, or
  will expenditure be constrained, or will there be
  inflation?
• The private sectors expectations about this will
  influence their response to fiscal policy.
• This is a big political economy problem. In my
  view it is not an issue in Australia or New
  Zealand at present there is no risk of such a
  debt expansion But it may be an issue at present
  in the US, or in Europe.

10
3.3 What else can an undisciplined fiscal policy
cause?

• Jan Libich presented an analysis of a responsible
  central banker and an over ambitious fiscal
  policy maker
• The fiscal policy-maker too ambitious and aims
  for too high level of output, or does not want
  the recession needed to control inflation
• What kind of commitment would prevent this kind
  of conflict leading to a bias to too high a level
  of inflation?
• What kind of institutional arrangements would
  prevent this fight?
• Doug Laxton presented an analysis of the effects
  that an undisciplined US fiscal policy has on the
  US current account deficit
• Not the major cause of that problem
• But reducing the fiscal deficit would reduce the
  current account deficit .

11
3.4 Modelling

• What can we learn from models
• Paper presented by Renée Fry on developing a good
  empirical model, which really does incorporate
  the interaction of monetary and fiscal policy
• How do people learn?
• Paper presented by Bruce Preston
• Simple stories about Taylor rule macro may
  over-simplify
• And if Leeper is right, learning about whether
  fiscal policy really will constrain public debt
  is important in understanding any effects of
  fiscal policy in stabilising the economy

12
4 Fiscal policy in longer term the constraint

• 4.1 Stimulating national savings
• It may be desirable to establish a future fund,
  if private savings is too low, not for temporary
  reasons or to do with a temporary shock, but,
  say, because the private sector discounts the
  future too much and there is initially too little
  savings for the future
• eg. unfundend pension liabilities
• This would have the effect of increasing the
  public sector surplus, ceteris paribus
• This would stimulate investment,
• it would lower interest rates
• and the exchange rate
• and thereby lead to the accumulation of capital
  (and foreign assets)

13
4.2 Stimulating infrastructure spending

• It may be desirable to invest more in
  infrastructure, not for temporary reasons or to
  do with a temporary shock, but because there is a
  shortage of it and the rate or return in it is
  higher than on private capital
• Either this could be paid for by increasing taxes
  
• Or it would lead, while it happened, to
• higher interest rates
• an appreciated exchange rate
• a dampening of the accumulation of private
  capital (and foreign assets) as well as
  depressing consumption

14

• 4.3 Stimulating national savings when there is a
  permanent terms of trade boom
• There may be good political economy reasons for
  setting up a future fund at the time of a terms
  of trade boom if it is also judged that there is
  initially too little savings for the future
• eg. unfundend pension liabilities
• This would impose an outcome in which the
  permanent increase in income did not lead to a
  permanent and immediate increase in consumption
  expenditure (as it would if people were forward
  looking
• Such a permanent increase in income would also
  lead to a demand for more capital in the economy
  ,
• and so investment
• and so a rise in real interest rates
• and so an appreciation in the exchange rate.
• A policy like this would dampen those short-term
  responses.
• This future fund would be being established to
  correct an initial (long run) suboptimality of
  too little savings
• doing at the time of a (permanent) rise in the
  terms of trade would have the effect of damping
  the short-run effects of the (permanent) rise in
  real income .

15
4.4 Stimulating infrastructure spending when
there is a permanent terms of trade boom

• There may be good political economy reasons to
  increase spending on infrastructure at such a
  time if it is judged that there is initially too
  little infrastructure
• This policy would mean that some of the permanent
  increase in income did lead to an increase in
  spending, in addition to the increase in
  consumption which it would cause if people were
  forward-looking
• Such a permanent increase in income would also
  lead to a demand for more capital in the economy,
  and so
• investment and
• so a rise in real interest rates
• and an appreciation in the exchange rate.
• This extra infrastructure expenditure would
  enable one to correct an initial (long run)
  suboptimality of too little infrastructure. But
  doing this at the time of a (permanent) rise in
  the terms of trade would have the effect of
  increasing, not damping, the short-run effects of
  the (permanent) rise in real income
• It would only damp these to the extent that it
  increased productive potential, which would only
  happen gradually.

16

• There may be some advantage in both
• setting up, or expanding, future funds, and
• Increasing infrastructure expenditure
• at the same time as a permanent (or
  long-lasting) improvement in the terms of trade,
  as in Australia at present
• Both may be justified as correcting pre-existing
  suboptimalities, about the quantity of savings
  and the quantity of infrastructure
• But one should not mix them up.
• And they point in opposite directions in the sort
  run. One dampens the short-run macroeconomic
  effects of the permanent increase in the terms of
  trade shock. The other may magnify these effects,
  in a procyclical way.

17
5 Conclusion

• The conference discussed the gradual
  establishment of a framework of constrained
  discretion for fiscal policy in Australia and New
  Zealand
• In both economies there is an inflation targeting
  regime in which
• monetary policy sis responsible for the short run
  stabilisation of the economy
• In both economies there is concern both about
• The discretion - what should fiscal policy do to
  help monetary policy stabilise the economy in the
  short-run?
• the constraint what should be the long run role
  of fiscal policy?